Greece has erupted. Public servants have taken to the streets, furious over threats to their jobs and perks. Much of the population is behind the rioters – more than half don’t agree with government plans for ‘austerity’ cuts, reports the Financial Times. Protestors have been storming the Acropolis, while flights and ferries in and out of the country have been suspended amid a general strike. Already, at least three people have been killed in the rioting. And it’s all down to the euro.
Last weekend the eurozone countries promised to lend Greece €110bn over the next three years. The bail-out is needed because it now costs the country too much to borrow in the open market. In October, the Greek state could still borrow for a five-year term at 3.2%; yet at one point last Wednesday, Greek five-year bond yields had spiked to more than 12%. There are ex-bankrupts who can borrow more cheaply than that.
How did all this happen? Greece joined the euro with every intention of enjoying all the privileges (largely consisting, ironically, of lower borrowing costs), but without taking on any of the responsibilities of adhering to the European Union’s strict monetary policy and tough fiscal rules. Instead, the Greek deficit numbers were fudged. When the country joined the euro, it was already spending far more than it could afford. But the final straw for the markets – already concerned about Greece’s double-digit budget deficit – came when the European statistics agency, Eurostat, revealed that the Greek deficit was actually 13.6% last year, rather than the 12.7% first quoted. And it could be revised to above 14%. Bond yields shot up, necessitating the current bail-out. And the people took to the streets.
Cosmo agony aunt, Irma Kurtz, once said, “givers have to set limits because takers rarely do”. Yet although the Greek politicians are making the right noises about austerity measures now, there’s no guarantee that voters won’t just throw them out. That’s even though some of these ‘austerity’ proposals would be considered quite normal in many other countries. The retirement age is being raised to 67, only a year later than the Conservative’s proposal for Britain.
So Greek debt is hardly home clear yet. The eurozone deal – assuming it goes through – means the country should be able to borrow at reasonable (below-market) rates. But it could still default on its outstanding debt. Greek five-year yields at first fell from their 12% peak on news of the deal, but surged back to 12.5% amid the riots. And even the €110bn may not be enough to tide Greece over if it can’t return to the private markets by the end of 2011.
But this isn’t just about Greece. It’s about the countries lining up behind it too. Next on the list, at least according to the credit default swap (CDS) market, is Portugal, where five-year government bond yields hit the wrong side of 6% during last Wednesday morning’s mayhem. Should Portugal also fall prey to the contagion, there’s the remaining peripheral countries (dubbed the PIIGS) to consider. Ireland looks most vulnerable, but Spain and Italy represent much more substantial potential problems. This raises the big question, lurking behind the headlines: is this the beginning of the end for the euro?
Can the euro survive?
The euro has fallen more than 15% against the US dollar since the Greek crisis kicked off. Given that the currency had gained 77% against the dollar since early 2002, we should keep this recent sell-off in perspective. Nevertheless, the Greek crisis does throw the problem at the very heart of the euro into stark relief. How are imbalances between countries to be reweighted in the absence of currency revaluation?
In the old days, if the Greek public sector’s profligacy drove the deficit into unsustainable excess, the drachma fell accordingly. Rather than workers’ ridiculously unproductive salaries having to be cut, the currency would instead be devalued by a third. What should be happening this summer is that all of northern Europe should be preparing to surge onto Greek beaches, ready to enjoy a super-cheap holiday. Meanwhile, the cost of BMWs would increase by 50% in Greek showrooms, snuffing out the demand for luxury imports and narrowing the trade deficit too. This has been such a good (and relatively painless) system over the years that it seems in hindsight an obvious one for politicians to have messed with.
Greece and any other eurozone country that finds its debt-fuelled way of life impossibly expensive to finance no longer has rectitude imposed on it by the market. That may delay the pain, and feel good in the short term. But when things come to a head, the remaining options aren’t pleasant, as Greece is now discovering.
On the one hand, instead of the relatively soft default of currency devaluation, there’s only the ‘hard’ version of a good old-fashioned repayment default. Do that and no one will lend you any more money at all (hence the need for the IMF/EU bail-out).
On the other hand, you could always try and live within your means. But for countries with deficits the size of Greece’s, this latter prospect is pretty unpalatable. The Irish economy, which has had to address a huge banking bust in an economy already too dependent on finance and real estate, has shrunk by 19% since the first quarter of 2007.
So who might be next?
Markets are most concerned about economies that look like Greece’s. Next on investors’ hit lists is Portugal. Last September, Portugal’s five-year CDS spread was the lowest of all the PIIGS. In other words, it cost less to insure Portuguese debt against default than any of its periphery peers. And Portugal’s government debt, at 77% of annual GDP, is about average for the eurozone, and much lower than that of Greece. But in terms of its structure, Portugal looks too much like Greece – a small, unbalanced economy with very little wiggle-room.
And something else makes it an easy target – it’s economically irrelevant within the greater European bloc. Portugal can’t benefit from the weaker currency that would better reflect its situation. But it can’t get the correct monetary policy either (eurozone monetary policy reflects what’s best for Germany and France).
The eurozone has no formal mechanism as yet for transferring tax income from one country to another (although as the bail-out shows, it’s getting there by trial and error), so Portugal can’t benefit from that. Yet it may well have to contribute to Greece’s rescue. Most important of all, in the end, Portugal may be better off simply defaulting on its debt, rather than having to abide by the stringent terms of any bail-out.
The crisis in Europe clearly shows the downside of the global banking bail-out. When they realised that the banks were essentially bust, governments transferred a lot of private-sector banking risk onto their countries’ balance sheets. In some cases, this has generated deficits that threaten the apparent solvency of the countries themselves. Once you throw in the enormous unfunded pension and healthcare commitments that many Western countries have, the long-term debt-to-GDP ratios start to look truly frightening. This is by no means restricted to eurozone countries – Britain’s budget deficit is nearly as bad as Greece’s.
Could Britain or America follow?
So could a major non-eurozone economy be next in the firing line? If the markets deem that governments will have trouble servicing their debts, they will run scared, driving up borrowing costs, as they have with Greece. But Greece suffered from two conditions that make it rather different to Britain, let alone America.
The first, as we’ve already noted, is that it has no currency to devalue. The second is that Greece, like Ireland, has an extremely unbalanced, inflexible economy. Within the larger, more diversified economies of the G7, government spending patterns can be changed and private-sector recovery can be promoted. Although hardly painless, lenders understand that it can be done.
For example, when Britain turned to the IMF for a handout in 1976 the government asked for £2.3bn. That was less than 2% of GDP at the time. It was more of a shock tactic to prove that restructuring plans were serious, than a last-ditch cry for help. Greece’s bail-out loan, on the other hand, is equivalent to 46% of GDP – and yet still may not be enough, according to some accounts.
That’s not to say there won’t be painful adjustments for Britain; merely that, unlike Greece, we are in a position to make these changes happen. During the last three weeks, the CDS insurance on Greek five-year bonds has taken the yield up by over 6%; UK five-year gilt yields actually fell by 0.2%. The bond market is telling us that it expects a huge raft of austerity measures in Britain right after the election and we’d be foolish to ignore that. The good news is that we should therefore avoid a Greek-style crisis and bail-out. The bad news is that, for taxpayers and those on benefits alike, it’s no more Mr Nice Guy from the state.
Unfortunately, the same can’t be said for other eurozone countries. The European response to this crisis has been a muddled disaster – subscale, reluctant and reactive, rather than determined and proactive. Markets now have no confidence that future crises – which could be just around the corner – will be dealt with effectively. In fact, Angela Merkel has almost promised as much.So credit markets remain almost as heavily sold off as before the bail-out deal news.
However, liquid safe havens such as US Treasuries, German bunds and even UK gilts, are all up. Markets are now playing a more sophisticated, political game than the one of 12 months ago. Now it’s not the most indebted countries that are being targeted as the most likely to fail. Instead, investors are aiming at the most hamstrung. This has become an assault on the integrity of European monetary union itself.